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Financial Projections: The Top-Down Approach
Financial projections cause headaches to many entrepreneurs. The main purposes of this article are clarifying the major doubts around this topic and giving guidelines on the methods, the mindset to adopt when computing projections and the tools and tips that may be useful in the process.
The two main methods to calculate financial projections
There are two main, widely adopted approaches to estimate financial projections:
- bottom-up: it is also referred to as “inside-out” because it starts by estimating internally available resources to then project them into the future.
- top-down: or “outside-in”, that starts from external data on the market size and then estimates market share and revenues target you can achieve to then workout subsequent implications for your organisation.
Which method is most suitable?
The key differences between the two approaches lay in their assumptions. The choice depends then on the purpose of the projections.
The main assumption of the bottom-up approach is that you will be able to sell everything you are able to produce. This does not imply that companies do not raise capital or use external financing. However, they mainly use internally generated cash-flows to grow their business. The purpose of the projections may be, for instance, to assist internal management or exit planning.
With the top-down approach, the main assumption is that the resources to get to a certain growth path, revenues or market share target are available and easy to acquire. In other terms, it implies that you are going to be able to raise capital to reach those milestones. This is the reason why this method is most suitable for startups in the process of raising capital, thus estimating resources to achieve certain goals and growth.
The top-down approach to financial forecasting
This method is usually adopted by companies that have very wild ambitions and growth potential because of, for example, an innovative product or market.
The main advantage of the top-down approach is that it allows you to determine a growth path that can be explained and agreed with investors. If they agree on the growth path you forecast, they will probably agree on the valuation that results from these projections. Moreover, they will be able to measure your performance based on those specific KPIs. For these reasons, it shows a lot of potential and ambition while at the same time being trackable over time.
1| Estimate market size, market share and revenues
The first step is to estimate the size of the target market. There are several theories on this topic, among which the TAM (Total Available Market), SAM (Serviceable Available Market), SOM (Serviceable Obtainable Market) approach.
A practical example
For an ice-cream business, the TAM is represented by the supermarket ice-cream sector in Europe. This is the total amount of revenues a company can earn assuming that it will be able to get 100% market share.
Given the stage of the company and other reasons, the ice-cream factory only targets its home country, e.g. The Netherlands. The result is its SAM, a fraction of the total European market.
SOM is calculated by estimating how much of SAM it is able to get, e.g. 10% market share of supermarket ice-creams in The Netherlands by 10 years.
For more advise on how to estimate the market size, check out this article.
How to estimate market share?
It is very important to relate to the current market leader to estimate the future market share. If, for example, the current market leader has 5%, you most likely will not be able to get a 10% market share. If the leader is an old and established company and it was able to get only 5%, it probably means fierce competition in the industry. For the sake of having defensible projections and clear milestones in the eyes of investors, the most suitable maximum estimated market share of the example would be 5%.
2| Set your target EBITDA
Giving revenues and operating costs, the company should be able to generate an operations margin. For startup companies, this margin should be in the range between 5% and 20%, depending on the length of the horizon. Most entrepreneurs expect exponential growth in revenues and a slower growth in costs. Every investor knows that growth comes at a cost; a lot of the most successful startups still “struggle” for profitability because they are sacrificing it for the sake of growth. Setting a lower, more reasonable, target operating profitability (or EBITDA margin) shows investors that your business model is sustainable. It also leaves room to say that if the company keeps on growing at this pace, it can wave its profit and reinvest the generated in cash into the operations to grow more. Every investor will agree on sacrificing current profits for a larger sum tomorrow: profitability is an option.
3| Estimate costs
Having set your target EBITDA, you will know how much costs you will have to sustain to reach your targets. You should then identify the cost categories that are most important for your business model, and apply target ratios. To do this, you can apply your own expertise, ask your network to share their experience or rely on benchmark public companies that have similar business model (they don’t necessarily have to be in your same industry, similar business model is more important). Referring to them will help you defend your projections in front of investors.
When setting these proportions you should ask yourself questions such as: which proportion of your costs should be dedicated to a sales team? Which percentage to IT?
Using ratios when estimating costs is a handy system because it makes your projections easy to read and to agree with, as well as to easy change in case investors believe you should allocate more resources to a particular aspect of your business.
Make your projections using this Free Financial Projections Template, an already made Excel spreadsheet with clear and simple guidelines to follow in estimating your future numbers.
What is your experience with financial projections and which questions would you like an answer to? Let us know in the comments.